Paul Chesson, head of Japanese Equities at Invesco Perpetual, says that Japan needs to foster its relationship with its biggest trade partner China.

As a key trading partner, Japan’s economy was impacted by China’s slowdown and by the island dispute in 2012. How will Japan’s economy fare in 2013?

Japan’s economy had a strong start in 2012, partly supported by post-earthquake reconstruction activity and consumption, but growth then slowed quite sharply, impacted especially by the slowdown in China.

China is Japan’s largest trading partner, so this is unsurprising, and the lack of domestic drivers of growth in Japan as a result of deflation and lack of population growth continues to leave Japan’s economy and its exporters vulnerable to changes in the global economy.

The good news is that the United States, which economically speaking is almost as important as China to the Japanese, has continued to recover, especially for key industries such as car manufacturing. With the housing market in the US beginning to show signs of revival, this is encouraging news for the outlook for 2013.

Toward the end of 2012 we thought China also started to show signs of bottoming. China and the United States accounted for 42% of Japan’s exports in October, therefore we expect Japanese growth in 2013 to be no worse than 2012.

This is an important conclusion, because we think that current share prices are implying a much gloomier outlook.

What about trade with China?

However the current dispute over what the Japanese call the Senkaku island chain has already had a negative impact. The key question is whether that impact is durable.

Historically, diplomatic spats between the two countries have been short lived, and in my opinion it is true that the two nations need each other. China needs Japan’s technology and inward investment, and Japan needs China’s growing market for both consumer and capital goods, and services. The impact of those factors is intangible, but what is clearer is that so long as the Japanese make things the Chinese want to buy, they will buy them.

For example, one area of demand that was affected by the island dispute was Japanese camera sales. Canon and Nikon enjoy more than 90% market share in digital SLR cameras. If the Chinese want to buy such a camera, they do not have a lot of choice other than to buy Japanese. If you make things that people want to buy and you make them competitively, then you have little to fear from politics, so long as markets are open.

I do not know how this dispute will ultimately be resolved. Within weeks of the consumer boycotts of Japanese goods, Chinese consumers were once again returning to Japanese brands, suggesting the impact has indeed been short lived. However the on-going impacts of the dispute is something we will need to keep an eye on.

Currency

Another factor we will be monitoring carefully is the strength of the yen.

The yen has been seen as a “safe-haven” currency, at a time when investors have been worried about the risk of devaluation of other currencies such as the American dollar and the euro. With 10 year interest rates at below 1% in 2012, we believe investors cannot have been finding yen deposits especially attractive. We think this “safe-haven” status is being gradually undermined.

As we move through the economic healing process, especially in the US, and as the risk of ever more aggressive monetary policy subsides, I believe investors will begin to hate the dollar a little less, and fall out of love with the yen a little more. The five year high for the yen against the dollar was back in 2011, which suggests this is already happening.

However a weak yen is not a panacea for Japan but, if it proves to be a catalyst for unlocking the value from Japanese companies shares, then I welcome it.